The 4-1-1 on 403(b) Plans

Millions of American workers save for their retirements in 401(k) and other qualified plans. However, employees of not-for-profit organizations are n­­­ot eligible to use these plans, as they can only be used in the private sector. They must instead use an equivalent plan known as a 403(b) plan. These plans resemble 401(k) plans in many respects, but are specially designed for nonprofit entities. This article examines the basic characteristics of these plans and how they work. (For more on 401(k)s, see The 4-1-1 On 401(k)s.)Background and Structure403(b) plans are a type of defined-contribution plan that allows participants to shelter money on a tax-deferred basis for retirement. These plans were created in 1958, and were originally known as tax-sheltered annuities (TSA) or tax-deferred annuities (TDA) plans because they could only be invested in annuity contracts at that time. These plans are most commonly used by educational institutions, although other nonprofit organizations use them as well. Any entity that qualifies under IRC Section 501(c)(3) can use this type of plan.

Contribution and Deferral LimitsThe contribution limits for 403(b) plans are now identical to those of 401(k) plans. All employee deferrals are made on a pretax basis and reduce the participant's adjusted gross income accordingly. For 2010, the contribution limit is the lesser of the employee's compensation or $16,500. An additional catch-up contribution of $5,500 is allowed for workers age 50 and above.

403(b) plans offer a special additional catch-up contribution provision known as the lifetime catch-up provision, or 15-year rule. Employees who have at least 15 years of tenure and have contributed an average of $5,000 per year or less are eligible for this provision. For more information on the 15-year rule, consult IRS Publication 571.

Employers are allowed to make matching contributions, but the total contributions from employer and employee cannot exceed $49,000 in 2010. After-tax contributions are allowed in some cases, and Roth contributions are also available for employers who opt for this feature. Recent legislation has also allowed employers to institute automatic 403(b) plan contributions for all employees, although they may opt out of this at their discretion. Eligible participants may also qualify for the Retirement Saver's Credit.(For a complete 403 (b) plan guide, read our 403(b) Plan Tutorial.)

RolloversThe rules for rolling over 403(b) plan balances have been loosened considerably over the past few years, and employees who leave their employers can now take their plans with them to another employer if they don't roll their plans over into a self-directed IRA. They can roll them over into another 403(b) plan, a 401(k) or other qualified plan. This allows employees to maintain one retirement plan over their lifetimes instead of having to open a separate IRA account or leave their plan with their old employer. (Find out how to choose between Roth IRAs, Traditional IRAs and 401(k)s. Check out Which Retirement Plan Is Best?)

Distributions403(b) plan distributions resemble those of 401(k) plans in most respects. Distributions taken before age 59.5 are subject to a 10% early withdrawal penalty, unless a special exception applies. All normal distributions are taxed as ordinary income at the taxpayer's top marginal tax rate. Roth distributions are tax free, although employees must either contribute to the plan or have a Roth IRA open for at least five years before being able to take tax-free distributions.

Mandatory minimum distributions, which are calculated according to the recipient's life expectancy, must begin at age 70.5, unless the plan is rolled over into a Roth IRA or other Roth retirement plan before then. Failure to take a mandatory minimum distribution will result in a 50% excise tax on the amount that should have been withdrawn. Loan provisions may also be available at the employer's discretion. The rules for loans are also largely the same as for 401(k) plans; participants cannot access more than the lesser of $50,000 or half of their plan balance, and any outstanding loan balance that is not repaid within five years is treated as a taxable or premature distribution. All distributions are reported each year on Form 1099-R, which is mailed to plan participants.

Investment ChoicesThe majority of 403(b) plans are still funded with annuity contracts, despite the fact that the Employee Retirement Income Security Act (ERISA) permits these plans to invest directly in mutual funds. This is, in fact, a source of ongoing debate in the financial and retirement planning community, since annuities are tax-deferred vehicles in and of themselves, and there is no such thing as "double" tax-deferral. Most plans now offer mutual fund choices as well, albeit inside a variable annuity contract in most cases. But fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans; other securities such as stocks, REITs and UITs are prohibited. (For more information on this issue, see Are You Buying Annuities or Mutual Funds?)

Miscellaneous Issues403(b) plans differ from their 401(k) counterparts in that they have no vesting provisions. However, they do now provide the same level of protection from creditors as qualified plans. Plan participants should also be aware of all of the costs and fees being charged by their plan and investment providers; these fees can include annual administrative charges, investment management fees such as 12b-1 fees, mortality and expense charges for annuity contracts and front or back-end sales charges for mutual fund purchases. The plan administrator must provide a complete breakdown of these fees to all plan participants.

Conclusion403(b) plans are used in the nonprofit sector to allow employees to save for retirement. Although these plans closely match 401(k) plans in many ways, there are still a few differences in how they work. However, the two types of plans can now be rolled over between each other. For more information on 403(b) plans, visit the IRS website at http://www.irs.gov/ and download Publication 571.